Lenders Bank Roll Enterprise Blockchain, But Adoption Limited

The potential of enterprise Blockchain to reduce costs and streamline the banking industry has spurred banks to invest heavily in research. Use cases span broadly from cross-border payments, clearing and settlement, KYC procedures, trade finance, loan syndication to the implementation of smart contracts. And while there has been a lot of motion, Blockchain has seen limited large scale adoption.

While banks have traditionally been sceptical of cryptocurrencies, they have embraced the underlying technology as a solution for inefficiencies, security concerns, accuracy, transparency, but mainly for its potential to cut operational costs.

Accenture, which strives to be a forefront of Blockchain innovation, claims that the implementation of Blockchain could save investment banks 30% of operational costs. This was also echoed by Bank of England (BoE) Governor Mark Carney, stating that Blockchain could save banks “tens of billions of pounds of bank capital” (See Graph 1).

Banks interest lie in enterprise Blockchain rather than the conventional Blockchain that underpins cryptocurrencies such as Bitcoin. The main difference between the two is that the enterprise Blockchain is private, which means that network participants have the ability to choose who joins the network and who can participate in the consensus process. Instead of proof of work, the network participants also decide who in the network validates a particular transaction. The selective enforcement requires a lot less energy than proof of work but is considerably less secure which depends merely on the honesty of participating entities that are validating the transactions.

A Swift Kick By Ripple?

The first and the most obvious use case for enterprise Blockchain is a cross-border payment network.

San Francisco based Ripple has developed a global settlement network for fiat currencies, commodities and other units of value that enables "secure, instant and nearly free global financial transactions of any size with no chargebacks". Because the transactions are nearly instant, the credit and liquidity risk is eliminated. This also minimizes settlement risk and thus lowers total cost of settlement. In October, Ripple surpassed 100 financial institutions that participate in their global payment system.

The Society for Worldwide Interbank Financial Telecommunication (SWIFT) is owned by banks and has a monopoly on sending and receiving information about financial transaction. SWIFT, currently supported by more than 11,000 financial institutions has since launched their own Blockchain proof of concept. Regulators can run their own read-only node in the Blockchain global settlement networks such as Ripple and oversee all the transactions without having to ask for any additional information from individual parties. But this too has a far way to go before being deployed in any large scale that will benefit all the SWIFT institutions equally.

Another company that is heavily invested in global payments on Blockchain is R3, which leads a consortium of more than 70 of the world's biggest financial institutions. It developed an open-source distributed ledger system called Corda. R3 states that it “captures the benefits of Blockchain systems, without the design choices that make Blockchains inappropriate for many banking scenarios.” Thus, it is not technically a Blockchain solution.

The second use case is an implementation of Blockchain for clearing and settlement which is currently seeing the most development. The industry is structured around centralized institutions, which are resource intensive and low frequency. Accenture estimated that investment banks can save up to $10bn if they use Blockchain to improve the efficiency of clearing and settlement. The orders are matched instantly but it currently takes approximately three days to settle the swap between the counterparties.

Adam Ludwin, CEO and Co-founder of Chain, a startup that developing enterprise-grade Blockchain infrastructure, believes that Blockchain technology will make clearing and settlement redundant. In May, Chain along with Citi and Nasdaq launched a Blockchain driven payment system for private equity. R3's founder and a managing partner David Rutter is not as optimistic in the short run. He believes that Blockchain application in clearing and settlement is currently under regulatory and legal constraints with hundreds of countries, which are slowing down innovation.

Flurry Of Activity

The Australian Stock Exchange has selected Digital Asset Holdings, a New York based startup headed by Blythe Masters, to develop a Blockchain post-trade clearing and settlement system.

The London Stock Exchange Group’s subsidiary is also developing a Blockchain solution in conjunction with IBM to digitize the issuance of securities for SMEs. And a consortium of seven of Europe’s largest banks (Deutsche Bank, HSBC, KBC, Natixis, Rabobank, Societe Generale and Unicredit) hired IBM to launch a trade finance platform for SMEs to digitalize trade finance.

Depository Trust & Clearing Corporation (DTCC), which settles the vast majority of securities transactions in the United States, announced that it is working with IBM, Axoni and R3 to develop a post-trade processing Blockchain solution. Michael Bodson, CEO of DTCC said that there has not been a practical rollout of Blockchain technology for post-trade processing on a large scale yet but that this “the first time globally where we are using distributed ledger technology to become a piece of the infrastructure in a very critical market, in the credit default swaps market, and use it across the entirety of multiple players.” Implementation of Blockchain solutions could increase the trade accuracy, reduce complexity and shorten the settlement process, which would consequently save banks billions of dollars.

Regulatory Risk Mitigation

On average, a bank spends more than $52 million a year on Know-Your-Client (KYC) compliance and penalties for failing to follow regulations according to a Reuters Survey. KYC processes are currently not unified or shared effectively amongst financial institutions, which creates duplication of effort and results in wasting time and resources. KYC requests take from 30-50 days to complete. There have been attempts to set up and maintain a KYC registry where banks would share KYC documentation but only with limited success.

SWIFT has a KYC registry but only 16% of the banks in their system participate. The biggest issue with a centralized KYC registry is the problem of deciding liability. By implementing a Blockchain solution, cryptography would enhance security and KYC entries could be updated instantly.

The process would also be automated, which would reduce compliance errors and thus also penalties (See Graph 2). Moreover, a Blockchain KYC solution would create a historical time stamped record of all entries where it would be possible see which banks added the documents and when. Regulators could therefore check the record if they needed further clarification whether a bank has acted in accordance with the regulations. According to Goldman Sachs, by streamlining the KYC process, banks could also reduce 10% of headcount and minimize KYC and AML penalties.

1: 2016 Selected Banks Noninterest Expense (Mn USD)

Source: Annual Company Filings

2: Global Lenders Payout $321Bn In AML Penalties Since 2009 (Bn USD)

Source: Bloomberg, BCG

There are several startups including Cambridge Blockchain, KYC-Chain, Trunomi, Tradle and Blockchain HELIX that are developing their KYC Blockchain solutions. Recently, Accenture partnered with Avanade to create a digital identity database based on Blockchain for over a billion of people. The software tool was developed to let undocumented refugees identify themselves through a phone with their biometric data.

The other potential use cases include the digitization of the still paper based ecosystem of trade finance. Wave, an Israeli startup, aims to digitalize the bill of lading. Wave is competing against Bolero and essDocs, which have their own conventional digital bill of lading solutions but both of these services haven’t gained much traction on the market.

Wave is hoping that their solution will succeed by eliminating trust in a central entity. However, the trade finance ecosystem could take years to transform and business process changes are necessary for its success.

Similarly to trade finance, Blockchain could also innovate the outdated process of Loan Syndication. A consortium of banks led by Credit Suisse is conducting syndicated loan trial and is looking to launch a commercial platform in the following year.

Smart Contracts can potentially disrupt how banks operate. The ability to self-execute a payment upon a consensus from the network and partially automate contract law would be extremely innovative for banks. The contract would, in advance, define the obligations, benefits and penalties and then self-execute itself based on the underlying circumstances.

Physical contracts are inefficient, could cause delays and the legal costs are expensive for both parties. In banks, smart contracts could be used especially for mortgages or bonds.

Central Banks Growing Ears

There are some central banks, which have and are testing Blockchain’s capabilities. The Bank of Canada, in conjunction with R3, conducted a Blockchain experiment that looked into the feasibility of Blockchain to create new distributed wholesale payment system. After a year-long investigation it concluded that there are currently too many hurdles and that the technology is not there yet.

The Bank of England selected Ripple, R3’s competitor, to test interledger protocol to see whether Blockchain technology could effectively enable connectivity between central bank systems and facilitate transactions between different Blockchains. It concluded that Blockchain technology is not sufficiently mature to support the system yet but that the solution showed promise and that it reinforced its intention to make the new payments settlement system fully compatible with Blockchain technology.

Peak Blockchain Hype?

Banking technology is quite outdated, inefficient and resource intensive. New approaches such as Blockchain can disrupt banking but are also constrained by established laws, regulations and business processes.

While Blockchain might not be a silver bullet, the hype surrounding it is creating pressure to innovate the outdated processes. Before implementing a Blockchain solution, it is important to ask whether the same problem cannot be solved more elegantly by a shared database.

Blockchain enables databases to be shared directly between multiple parties without relying on trust and without a central entity. So far, for the most part, banks have only been investing a lot of capital in Blockchain solutions but with limited adoption other than testing.

According to research company Gartner, Blockchain already hit the peak of its hype cycle and is at a peak of inflated expectations. Other than cryptocurrencies, Blockchain has not proven itself in any other use cases as of yet.

In order for enterprise Blockchain to be widely adopted, companies have to be open to cooperate with other companies. Companies represent nodes in the Blockchain, which creates a problem of confidentiality. Competing companies will have to share some information with each other. Even though there are cryptographic techniques that partially solve the problem of confidentiality, it can never be fully solved on Blockchain. Blockchain was designed to be transparent while banks, much like most businesses, do not want to be fully transparent with each other.

"Although it is still too early to determine how the technology will evolve and whether it is suitable for large-scale deployment, our pilot has demonstrated the clear strengths of private blockchain and its potential."

Xavier Toudoire, BNP Paribas

Apple Pay Continues Expansion, Enters Middle East

Apple has fulfilled on its third-quarter earnings call promise to deploy Apple Pay in three more European countries, Finland, Denmark and Sweden. The mobile wallet from the tech giant also entered the United Arab Emirates, 6 months after Samsung Pay entered the market in April 2017.

Apple Pay is now available in 10 of the 28 EU member states, but evidently missing on some major countries such as Germany and Netherlands where Apple is said to be eyeing their debut later in 2017. This is double the countries that Samsung Pay is available in the European markets, while Apple trails its competitor in Asia.

Number of countries accepting mobile payment/digital wallet

European Central Bank To Continue Stimulus Program Into 2018

With a sleight of hand, and twist of words, European Central Bank (ECB) President Mario Draghi announced an open-ended, albeit, “downsized” version of the Quantitative Easing (QE) program that has assisted the European Zone avoid deflation.

At €2.1Tn of asset purchases since 2015, double its original planned size, the ECB announced last week that it will be reducing its bond buying to €30Bn/Month from €60Bn after December this year. The halved bond buying program will continue deep into the first nine months of 2018.

However, the question remains whether or not the ECB would increase the program if inflation (which currently stands at 1.5%) should not pick up. Mr Draghi said that the 25-Member ECB Governing Council did not discuss the limits or the composition of the program.

The ECB also announced that rates will remain at the current record low of minus 0.4% for the deposit rate and 0% for refinancing.

While the European Union economy’s output and growth have been positive on the back of record low rates, the economic environment may not continue to be so favorable with brewing political turmoil in Italy and Spain, two of the EU’s largest economies.

And not all are happy with the open-ended program. Germany is worried of the repercussions of possible asset price bubbles and low return rates for savers. QE critic Jens Weidmann, Bundesbank President, whom Berlin wishes to succeed from Mr Draghi in 2019 said that “a clear ending to the net sales [of bonds to the ECB] should have been indicated.” However, even Mr Wiedmann believes that the European economy is not strong enough, yet, to pull all monetary support.

Lightning Network A Boon To Bitcoin Fungibility

With the recent arrest and soon extradition of Alexander Vinnik to the U.S. on money laundering charges, exchanges will be incentivized to use a centralized service to check the bitcoins’ history to avoid involvement with authorities. This questions a core component of Bitcoin, and if the currency can be made truly fungible.

One of the essential functions of fiat currencies is to serve as a unit of account. Bitcoin is currently both countable and divisible, however falls short on the third prerequisite of a currency in being fungible. Speaking to Diar, Chris Belcher, a Bitcoin developer and creator of JoinMarket, a decentralized solution that enhances Bitcoin’s privacy by confusing the trails of transactions, notes that Bitcoin is not currently fungible for casual users.

Because all bitcoin transactions are recorded on a decentralized public ledger, it is possible to track which specific bitcoins were previously associated with illegal activities such as theft, drug trade, ransomware or even gambling. This is in quite stark contrast with fiat currencies whereby merchants can accept bank notes without the regulatory requirement to check the provenance of those notes.

Belcher confirmed that some users of online Bitcoin casinos started getting banned by Coinbase. There are several startups such as Elliptic, Chainalysis, Blockseer, ScoreChain, Netki and Bloq that analyze Blockchain and identify the activity associated with transactions.

Elliptic, which focuses on identifying illegal activities was able to raise $7 million in funding. It provides actionable intelligence to financial institutions and law enforcement agencies. Belcher believes that blockchain analysis undermines bitcoin fungibility and privacy but thinks that both compliance and fungibility can co-exist.

Analyzing Bitcoin’s transactions could become an issue because the bitcoin exchanges can discriminate based on the coin’s history and therefore create price disparities on the market. Moreover, some exchanges can choose to discriminate to a higher extent than others, which creates even larger disparities in value of the same bitcoins. In theory, the coins with the highest value will be spendable everywhere while the coins with the lowest value will be the most problematic to spend.

Fiat currency differs in this very point and the value of a specific bank note is not dependant on the history of that note. It does not matter with whom the notes were associated with previously if they are not damaged or marked in some way. Even if the specific notes were involved in illegal activities, there is little chance for government to know which ones and diminish their value.

There is only anecdotal evidence of exchanges accepting illegally obtained coins and charging a premium.

If bitcoins were involved in illegal activities, converting them to fiat currencies would be considered money laundering and exchanges can not legally accept them. Public information then on “dirty” Bitcoins would be difficult to come by then as Exchanges then could be liable for money laundering.

In July, BTC-e owner Alexander Vinnik was arrested in Greece for exchanging stolen bitcoins from ransomware payments and other illegal activities. The Justice Department claimed that BTC-e laundered over $4 billion. Greek courts have ruled to extradite Vinnik to the U.S. for further prosecution.

What's in the Mix?

Currently, the issue can be minimized by the so-called mixing (tumbling) services, which mix the coins and therefore confuse the individual attempting to track its transaction history.

It is unclear whether mixing large amounts of coins does not violate the anti-structuring laws because it can be used for money laundering. In July, one of the largest mixing services Bitmixer.io stopped operating despite processing 65,000 BTC per month and earning steep profits. There is speculation that the site was threatened by law enforcement.

However, mixing is impractical as it adds one extra step before finalizing the transaction and also charges a fee. The fees usually range from 1-3% for private coin mixers. JoinMarket, which charges a much lower fee, has processed approximately 30 million USD in the last 13 months.

The lack of fungibility can be construed as an advantage that disincentivizes illegal activities. However, questions arise on what happens when someone receives a dirty coin unknowingly. Theoretically, exchanges have more resources and time to look into bitcoin’s history than an individual person, but this creates an information asymmetry. And under what laws and jurisdictions would certain Bitcoins be classified as “dirty”?

This problem is advocating for a centralized service such as a blockchain analysis company, which would execute background check into specific bitcoins and decide whether the coins are clean or dirty. But centralized institutions with power to determine the value of bitcoins go directly against Bitcoin’s core value. Currently, most individuals do not find it necessary to look into bitcoins’ history. But with time, there will be more bitcoins affected by illegal activities and the chance of coming across one will increase.

Belcher admits that the current Bitcoin blockchain lacks privacy but believes that by the eventual implementation of the Lightning Network, taking transactions off-chain will be a massive improvement for both privacy and fungibility. Bitcoin’s fungibility remains a problem for casual users but, as Belcher tells us, the implementation of Lightning Network would be a step in the right direction.

Mastercard Launches B2B Blockchain Pilot

Mastercard, who joined the Enterprise Ethereum Alliance (EEA) in late July 2017, has launched their Business-to-Business (B2B) Blockchain Application to facilitate cross-border payments throughout its 22,000 bank and financial institutions.

However, Mastercards Blockchain will still rely on a central authority for final verification as it will not actually transfer any value, but only register the transaction on the ledger. This means that transactions may not be faster than traditional means.

What the private blockchain may answer is quicker netting of the balances for Mastercard transactions across its own network, and then settlement in fiat using conventional methods.

Gab, Ad-Free Social Network, Aims For SEC Regulated ICO

Online free speech advocate start-up Gab, have announced that they will be issuing an Initial Coin Offering (ICO) that will be in full compliance with Securities and Exchange Commission (SEC) regulations. Gab has already raised over $1Mn through StartEngine.

Gab plans to raise capital through the path of Regulation A+ which requires a "two year IPO-level CPA audit, SEC qualification, and is limited to $50m per year in capital." This regulated ICO path allows for all kinds of investors, not just accredited ones.

In their announcement, Gab stated that StartEngine themselves, a crowdfunding platform that is registered with the SEC had approached them about plans to allow startups to raise capital through ICO's.